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Section 1: 10-Q (10-Q)

Document
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
 
FORM 10-Q

(Mark one)
 
 
[X]
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
 
 
 
For the quarterly period ended September 30, 2018
 
 
 
or
 
 
 
[ ]
 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
 
 
 
For the transition period from____________________ to____________________
 
 
 
Commission File Number: 1-11917
395600971_ffglogoa02.jpg
(Exact name of registrant as specified in its charter)
 
 
 
Iowa
 
42-1411715
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
 
 
 
5400 University Avenue, West Des Moines, Iowa
 
50266-5997
(Address of principal executive offices)
 
(Zip Code)
 
 
 
(515) 225-5400
(Registrant’s telephone number, including area code)
 
 
 
 
(Former name, former address and former fiscal year, if changed since last report)
 
 
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [X] Yes [ ] No
 
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). [X] Yes [ ] No
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one)
Large accelerated filer [ ]
Accelerated filer [X]
Non-accelerated filer [ ]
Smaller reporting company [ ]
Emerging growth company [ ]
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. [ ]
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). [ ] Yes [X] No
 
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:
 Title of each class
 
Outstanding at October 30, 2018
Class A Common Stock, without par value
 
24,786,498
Class B Common Stock, without par value
 
11,413


















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FBL FINANCIAL GROUP, INC.
FORM 10-Q FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2018
TABLE OF CONTENTS


PART I.
FINANCIAL INFORMATION
 
 
 
 
Item 1.
Financial Statements (Unaudited)
 
 
Consolidated Balance Sheets
 
Consolidated Statements of Operations
 
Consolidated Statements of Comprehensive Income
 
Consolidated Statements of Changes in Stockholders’ Equity
 
Consolidated Statements of Cash Flows
 
Notes to Consolidated Financial Statements
 
 
 
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
 
 
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
 
 
 
Item 4.
Controls and Procedures
 
 
 
PART II.
OTHER INFORMATION
 
 
 
Item 1A.
Risk Factors
 
 
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
 
 
 
Item 6.
Exhibits
 
 
 
SIGNATURES
 
    



1


ITEM 1. FINANCIAL STATEMENTS

FBL FINANCIAL GROUP, INC.
CONSOLIDATED BALANCE SHEETS (Unaudited)
(Dollars in thousands)

 
September 30,
2018
 
December 31,
2017
Assets
 
 
 
Investments:
 
 
 
Fixed maturities - available for sale, at fair value (amortized cost: 2018 - $6,925,616; 2017 - $6,757,250)
$
7,099,025

 
$
7,291,967

Equity securities at fair value (cost: 2018 - $99,882; 2017 - $96,715)
103,896

 
104,145

Mortgage loans
1,015,618

 
971,812

Real estate
1,543

 
1,543

Policy loans
195,723

 
191,398

Short-term investments
25,569

 
17,007

Other investments
48,636

 
42,371

Total investments
8,490,010

 
8,620,243

 
 
 
 
Cash and cash equivalents
14,425

 
52,696

Securities and indebtedness of related parties
59,546

 
47,823

Accrued investment income
81,199

 
76,468

Amounts receivable from affiliates
7,617

 
3,561

Reinsurance recoverable
104,550

 
108,948

Deferred acquisition costs
412,046

 
302,611

Value of insurance in force acquired
10,821

 
4,560

Current income taxes recoverable
1,454

 
6,764

Other assets
171,754

 
177,764

Assets held in separate accounts
651,797

 
651,963

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total assets
$
10,005,219

 
$
10,053,401


 


2




FBL FINANCIAL GROUP, INC.
CONSOLIDATED BALANCE SHEETS (Continued)
(Dollars in thousands)

 
September 30,
2018
 
December 31,
2017
Liabilities and stockholders’ equity
 
 
 
Liabilities:
 
 
 
Future policy benefits:
 
 
 
Interest sensitive products
$
5,451,535

 
$
5,299,961

Traditional life insurance and accident and health products
1,789,650

 
1,750,504

Other policy claims and benefits
51,820

 
44,475

Supplementary contracts without life contingencies
310,152

 
322,630

Advance premiums and other deposits
268,935

 
267,023

Amounts payable to affiliates
1,379

 
1,164

Long-term debt payable to non-affiliates
97,000

 
97,000

Deferred income taxes
77,958

 
130,425

Other liabilities
111,195

 
111,131

Liabilities related to separate accounts
651,797

 
651,963

Total liabilities
8,811,421

 
8,676,276

 
 
 
 
Stockholders’ equity:
 
 
 
FBL Financial Group, Inc. stockholders’ equity:
 
 
 
Preferred stock, without par value, at liquidation value - authorized 10,000,000 shares, issued and outstanding 5,000,000 Series B shares
3,000

 
3,000

Class A common stock, without par value - authorized 88,500,000 shares, issued and outstanding 24,806,796 shares in 2018 and 24,919,113 shares in 2017
153,160

 
153,589

Class B common stock, without par value - authorized 1,500,000 shares, issued and outstanding 11,413 shares in 2018 and 2017
72

 
72

Accumulated other comprehensive income
88,961

 
284,983

Retained earnings
948,530

 
935,423

Total FBL Financial Group, Inc. stockholders’ equity
1,193,723

 
1,377,067

Noncontrolling interest
75

 
58

Total stockholders’ equity
1,193,798

 
1,377,125

Total liabilities and stockholders’ equity
$
10,005,219

 
$
10,053,401


See accompanying notes.


3




FBL FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)
(Dollars in thousands, except per share data)

 
Three months ended September 30,
 
Nine months ended September 30,
 
2018
 
2017
 
2018
 
2017
Revenues:
 
 
 
 
 
 
 
Interest sensitive product charges
$
31,161

 
$
28,004

 
$
92,165

 
$
86,661

Traditional life insurance premiums
48,124

 
47,087

 
148,712

 
145,783

Net investment income
105,757

 
102,950

 
310,753

 
307,852

Net realized capital gains (losses)
(709
)
 
81

 
(1,615
)
 
599

Net other-than-temporary impairment losses recognized in earnings
(50
)
 
(67
)
 
(1,090
)
 
(133
)
Other income
3,828

 
3,501

 
12,065

 
11,711

Total revenues
188,111

 
181,556

 
560,990

 
552,473

 
 
 
 
 
 
 
 
Benefits and expenses:
 
 
 
 
 
 
 
Interest sensitive product benefits
70,145

 
67,206

 
194,127

 
188,217

Traditional life insurance benefits
44,168

 
42,633

 
133,349

 
128,197

Policyholder dividends
2,480

 
2,487

 
7,591

 
7,597

Underwriting, acquisition and insurance expenses
30,834

 
27,535

 
107,621

 
98,229

Interest expense
1,212

 
1,213

 
3,638

 
3,638

Other expenses
5,061

 
4,971

 
16,281

 
13,862

Total benefits and expenses
153,900

 
146,045

 
462,607

 
439,740

 
34,211

 
35,511

 
98,383

 
112,733

Income taxes
(4,818
)
 
(9,880
)
 
(14,462
)
 
(32,017
)
Equity income, net of related income taxes
1,642

 
487

 
3,441

 
2,629

Net income
31,035

 
26,118

 
87,362

 
83,345

Net loss (income) attributable to noncontrolling interest
(25
)
 
9

 
16

 
(20
)
Net income attributable to FBL Financial Group, Inc.
$
31,010

 
$
26,127

 
$
87,378

 
$
83,325

 
 
 
 
 
 
 
 
Earnings per common share
$
1.24

 
$
1.04

 
$
3.50

 
$
3.32

Earnings per common share - assuming dilution
$
1.24

 
$
1.04

 
$
3.50

 
$
3.32


See accompanying notes.


4




FBL FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)
(Dollars in thousands)
 
Three months ended September 30,
 
Nine months ended September 30,
 
2018
 
2017
 
2018
 
2017
Net income
$
31,035

 
$
26,118

 
$
87,362

 
$
83,345

Other comprehensive income (loss) (1)
 
 
 
 
 
 
 
Change in net unrealized investment gains/losses
(42,388
)
 
11,320

 
(191,339
)
 
73,751

Change in underfunded status of postretirement benefit plans
268

 
192

 
797

 
563

Total other comprehensive income (loss), net of tax
(42,120
)
 
11,512

 
(190,542
)
 
74,314

Total comprehensive income (loss), net of tax
(11,085
)
 
37,630

 
(103,180
)
 
157,659

Comprehensive (income) loss attributable to noncontrolling interest
(25
)
 
9

 
16

 
(20
)
Total comprehensive income (loss) applicable to FBL Financial Group, Inc.
$
(11,110
)
 
$
37,639

 
$
(103,164
)
 
$
157,639


(1)
Other comprehensive income (loss) is recorded net of deferred income taxes and other adjustments for assumed changes in deferred acquisition costs, value of insurance in force acquired, unearned revenue reserve and policyholder liabilities.


FBL FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (Unaudited)
(Dollars in thousands)
 
FBL Financial Group, Inc. Stockholders’ Equity
 
 
 
 
 
Series B Preferred Stock
 
Class A and Class B Common Stock
 
Accumulated Other Comprehensive Income
 
Retained Earnings
 
Non-
controlling Interest
 
Total Stockholders’ Equity
Balance at January 1, 2017
$
3,000

 
$
152,975

 
$
149,555

 
$
882,672

 
$
56

 
$
1,188,258

Cumulative effect of change in accounting for low income housing tax credit investments

 

 

 
(4,703
)
 

 
(4,703
)
Net income - nine months ended September 30, 2017

 

 

 
83,325

 
20

 
83,345

Other comprehensive income

 

 
74,314

 

 

 
74,314

Stock-based compensation

 
644

 

 

 

 
644

Dividends on preferred stock

 

 

 
(112
)
 

 
(112
)
Dividends on common stock

 

 

 
(70,280
)
 

 
(70,280
)
Receipts related to noncontrolling interest

 

 

 

 
(34
)
 
(34
)
Balance at September 30, 2017
$
3,000

 
$
153,619

 
$
223,869

 
$
890,902

 
$
42

 
$
1,271,432

 
 
 
 
 
 
 
 
 
 
 
 
Balance at January 1, 2018
$
3,000

 
$
153,661

 
$
284,983

 
$
935,423

 
$
58

 
$
1,377,125

Cumulative effect of change in accounting principle related to net unrealized gains on equity securities

 

 
(5,480
)
 
5,480

 

 

Net income - nine months ended September 30, 2018

 

 

 
87,378

 
(16
)
 
87,362

Other comprehensive loss

 

 
(190,542
)
 

 

 
(190,542
)
Stock-based compensation

 
366

 

 

 

 
366

Purchase of common stock

 
(795
)
 

 
(8,054
)
 

 
(8,849
)
Dividends on preferred stock

 

 

 
(112
)
 

 
(112
)
Dividends on common stock

 

 

 
(71,585
)
 

 
(71,585
)
Receipts related to noncontrolling interest

 

 

 

 
33

 
33

Balance at September 30, 2018
$
3,000

 
$
153,232

 
$
88,961

 
$
948,530

 
$
75

 
$
1,193,798


See accompanying notes.


5




FBL FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(Dollars in thousands)

 
Nine months ended September 30,
 
2018
 
2017
Operating activities
 
 
 
Net income
$
87,362

 
$
83,345

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Interest credited to account balances
123,425

 
121,028

Charges for mortality, surrenders and administration
(89,958
)
 
(86,975
)
Net realized (gains) losses on investments
2,705

 
(466
)
Change in fair value of derivatives
(2,370
)
 
(5,450
)
Increase in liabilities for life insurance and other future policy benefits
61,112

 
67,802

Deferral of acquisition costs
(31,276
)
 
(31,819
)
Amortization of deferred acquisition costs and value of insurance in force
24,199

 
15,984

Change in reinsurance recoverable
2,370

 
(488
)
Provision for deferred income taxes
(1,816
)
 
3,005

Other
1,050

 
7,055

Net cash provided by operating activities
176,803

 
173,021

 
 
 
 
Investing activities
 
 
 
Sales, maturities or repayments:
 
 
 
Fixed maturities - available for sale
455,104

 
444,130

Equity securities - available for sale

 
9,168

Mortgage loans
51,680

 
39,880

Derivative instruments
13,203

 
9,054

Policy loans
28,416

 
27,092

Securities and indebtedness of related parties
4,945

 
6,245

Real estate

 
717

Other long-term investments
4,948

 
14

Acquisitions:
 
 
 
Fixed maturities - available for sale
(613,278
)
 
(457,988
)
Equity securities - available for sale
(2,799
)
 
(1,102
)
Mortgage loans
(95,336
)
 
(147,200
)
Derivative instruments
(10,480
)
 
(6,556
)
Policy loans
(32,741
)
 
(29,090
)
Securities and indebtedness of related parties
(15,922
)
 
(10,178
)
Other long-term investments
(6,611
)
 

Short-term investments, net change
(8,562
)
 
(9,051
)
Purchases and disposals of property and equipment, net
(8,483
)
 
(7,889
)
Net cash used in investing activities
(235,916
)
 
(132,754
)




6




FBL FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
(Dollars in thousands)

 
Nine months ended September 30,
 
2018
 
2017
Financing activities
 
 
 
Contract holder account deposits
$
525,245

 
$
358,211

Contract holder account withdrawals
(423,714
)
 
(333,261
)
Dividends paid
(71,697
)
 
(70,392
)
Proceeds from issuance of short-term debt
27,000

 

Repayments of short-term debt
(27,000
)
 

Issuance or repurchase of common stock, net
(9,025
)
 
305

Other financing activities
33

 

Net cash provided by (used in) financing activities
20,842

 
(45,137
)
Decrease in cash and cash equivalents
(38,271
)
 
(4,870
)
Cash and cash equivalents at beginning of period
52,696

 
33,583

Cash and cash equivalents at end of period
$
14,425

 
$
28,713

 
 
 
 
Supplemental disclosures of cash flow information
 
 
 
Cash (paid) received during the period for:
 
 
 
Interest
$
(3,656
)
 
$
(3,638
)
Income taxes
(2,027
)
 
(10,302
)

See accompanying notes.


7


FBL FINANCIAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
September 30, 2018

1. Significant Accounting Policies

Basis of Presentation

The accompanying unaudited consolidated financial statements of FBL Financial Group, Inc. (we or the Company) have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. Our financial statements include all adjustments (consisting of normal recurring accruals) necessary for a fair presentation of our financial position and results of operations.

Operating results for the three- and nine-month periods ended September 30, 2018 are not necessarily indicative of the results that may be expected for the year ending December 31, 2018. We encourage you to refer to the notes to our consolidated financial statements included in Item 8 of our Form 10-K for the year ended December 31, 2017 for a complete description of our material accounting policies. Also included in the Form 10-K is a description of areas of judgments and estimates and other information necessary to understand our financial position and results of operations.

Accounting Policy Change

During the third quarter of 2018, we voluntarily changed our accounting policy for low income housing tax credit (LIHTC) investments from the equity method to the proportional amortization method. We believe the proportional amortization method is preferable because it better reflects the economics of an investment that is made for the primary purpose of receiving tax credits and other tax benefits and is consistent with the accounting method used by most life insurance companies that have disclosed their accounting policies for LIHTC investments. In addition to a change in the timing of the recognition of income or loss on LIHTC investments, there are also differences in how these investments are reported within our consolidated financial statements, as the unamortized cost of the LIHTC investments is now reflected in the "Other asset" line instead of the "Securities and indebtedness of related parties" line on the consolidated balance sheets and income/expense from LIHTC investments is now reflected in the "Income taxes" line instead of the "Equity income" line on the consolidated statements of operations. Changes to the consolidated statements of cash flows were immaterial and included moving additional funding and return of capital from LIHTC investments from the “Securities and indebtedness of related parties” lines under investing to the “Other” line under operating cash flows.

As a result of this accounting policy change, the opening balance as of January 1, 2017 of retained earnings was reduced by $4.7 million, as shown on the consolidated statements of changes in stockholders’ equity. In addition, the following presents the effect of the change on financial statement line items for prior periods that were retrospectively adjusted:

Consolidated Balance Sheet Impact
 
December 31, 2017
 
 
 
As Originally Reported
 
As Adjusted
 
Effect of Change
 
(Dollars in thousands)
Assets
 
 
 
 
 
Securities and indebtedness of related parties
$
130,240

 
$
47,823

 
$
(82,417
)
Current income taxes recoverable
3,269

 
6,764

 
3,495

Other assets
112,054

 
177,764

 
65,710

Total assets
 
 
 
 
$
(13,212
)
 
 
 
 
 
 
Liabilities and stockholders’ equity
 
 
 
 
 
Deferred income taxes
$
131,912

 
$
130,425

 
$
(1,487
)
Retained earnings
947,148

 
935,423

 
(11,725
)
Total liabilities and stockholders’ equity
 
 
 
 
$
(13,212
)




8

Table of Contents

Consolidated Statements of Operations Impact
 
 
 
 
 
Three months ended September 30, 2017
 
 
 
Nine months ended September 30, 2017
 
 
 
As Originally Reported
 
As Adjusted
 
Effect of Change
 
As Originally Reported
 
As Adjusted
 
Effect of Change
 
(Dollars in thousands)
Income taxes
$
(11,220
)
 
$
(9,880
)
 
$
1,340

 
$
(35,844
)
 
$
(32,017
)
 
$
3,827

Equity income (loss), net of related income taxes
2,804

 
487

 
(2,317
)
 
8,959

 
2,629

 
(6,330
)
Net income (loss) attributable to FBL Financial Group, Inc.
 
 
 
 
$
(977
)
 
 
 
 
 
$
(2,503
)
 
 
 
 
 
 
 
 
 
 
 
 
Earnings (loss) per common share - basic and assuming dilution
 
 
 
 
$
(0.04
)
 
 
 
 
 
$
(0.10
)

Net income would have been $0.1 million higher ($0.01 per basic and diluted share) for the three months ended September 30, 2018 and $0.2 million lower ($0.1 per basic and diluted share) for the nine months ended September 30, 2018 if the Company had continued to record LIHTC investments using the equity method.

New Accounting Pronouncements

Description
Date of adoption
Effect on our consolidated financial statements or other significant matters
Standards adopted:
Stockholders' equity
In February 2018, the Financial Accounting Standards Board (FASB) issued guidance allowing a reclassification from accumulated other comprehensive income (AOCI) to retained earnings for stranded tax effects resulting from changes in the federal income tax rate due to enactment of the Tax Cuts and Jobs Act of 2017 on December 22, 2017 (Tax Act). Accounting guidance requires that deferred tax assets and liabilities, including those associated with components of AOCI, be remeasured during the period new tax laws are enacted, with any changes reflected as a component of income tax expense (benefit). Under the previous guidance, retained earnings would reflect the full amount of the change and AOCI would not be adjusted for the portion of the change related to its components, leaving the unadjusted change “stranded” in AOCI. The new guidance allows AOCI to be adjusted to reclassify these stranded tax effects to retained earnings.
October 1, 2017
The new guidance was effective for 2018, with early adoption permitted. We adopted the new guidance in 2017 by reporting the reclassification in our Consolidated Statement of Stockholders’ Equity. We consider the remeasurement of deferred tax assets and liabilities a provisional estimate, so any adjustments to this estimate associated with components of AOCI during 2018 would result in additional reclassification. There have been no such adjustments during the nine months ended September 30, 2018.

Financial instruments - recognition and measurement
In January 2016, the FASB issued guidance that amended certain aspects of the recognition and measurement of financial instruments. The new guidance primarily affected the accounting for equity securities, which are now carried at fair value with valuation changes recognized in the statement of operations rather than as other comprehensive income. The presentation and disclosure requirements for financial instruments and the methodology for assessing the need for a valuation allowance on deferred tax assets resulting from unrealized losses on available-for-sale fixed maturity securities were also revised under the new guidance. The new standard required the use of a modified retrospective method at adoption.
January 1, 2018
Upon adoption, we reclassified $5.5 million of net unrealized investment gains, net of adjustments to deferred acquisition costs, interest sensitive policy reserves and income taxes, on our equity securities from AOCI to retained earnings as a cumulative effect adjustment. Adoption resulted in a decrease to net income of $2.4 million ($0.10 per basic and diluted earnings per share) during the nine months ended September 30, 2018 and $0.5 million ($0.02 per basic and diluted earnings per share) during the third quarter of 2018.


9

Table of Contents

Revenue recognition
In May 2014, the FASB issued guidance that outlined a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers. Insurance contract and investment related revenue, which make up the majority of our earnings, were specifically excluded from the scope of this guidance. The new guidance was based on the principle that an entity should recognize revenue to reflect the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance also required disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to fulfill a contract. We had the option of using either a full retrospective or a modified retrospective approach for the adoption of the new standard.
January 1, 2018
Our revenues that fall under the scope of the new guidance primarily consist of the net commissions on insurance and investment products we broker for others. We have evaluated those contracts and concluded that there was no change in timing or measurement of revenues, as the historical accounting is consistent with the new guidance. Accordingly, there was no impact from adoption.
Standards not yet adopted:
Leases
In February 2016, the FASB issued a new lease accounting standard, which, for most lessees, will result in a gross-up of the balance sheet. Under the new standard, lessees will recognize the leased assets on the balance sheet and will recognize a corresponding liability for the present value of lease payments over the lease term. The new standard requires the application of judgment and estimates. Also, there are accounting policy elections that may be taken both at transition and for the accounting post-transition, including whether to adopt a short-term lease recognition exemption.
January 1, 2019
We are currently evaluating the impact of this guidance on our consolidated financial statements, but do not believe it will be material. Our most significant lease is for our home office building. See Note 10 of Item 8 of our 2017 Form 10-K for a further description of this lease, including future commitments. Our other leases are primarily shorter term in nature, relating to equipment. This standard may be applied using the modified retrospective approach or prospectively, recognizing a cumulative effect adjustment.
Financial instruments - credit impairment
In June 2016, the FASB issued guidance amending the accounting for the credit impairment of financial instruments. Under the new guidance, impairment losses are required to be estimated using an expected loss model under which a valuation allowance is established and adjusted over time. The valuation allowance will be based on the probability of loss over the life of the instrument, considering historical, current and forecasted information. The new guidance differs significantly from the incurred loss model used today, and will result in the earlier recognition of impairment losses. The new guidance may also increase the volatility of earnings to the extent actual results differ from the assumptions used in the establishment of the valuation allowance. The financial instruments for which we will be required to use the new model include but are not limited to, mortgage loans, lease receivables and reinsurance recoverables. Our available-for-sale fixed maturities will continue to apply the incurred loss model. However, rather than impairment losses resulting in a permanent reduction of carrying value as they do today, such losses will be in the form of a valuation allowance, which can be increased in the case of future credit losses or decreased should conditions improve. 
January 1, 2020
We are currently evaluating the impact of this new guidance on our consolidated financial statements. We believe the most significant impact upon adoption will be the establishment of an additional valuation allowance for our mortgage loan investments. This guidance will be applied using a modified retrospective approach by recording a cumulative effect adjustment to retained earnings as of the beginning of the year of adoption.
Targeted improvements: long-duration contracts
In August 2018, the FASB issued guidance that will change the accounting for long-duration insurance contracts. The new guidance impacts several facets of the accounting for such contracts including the accounting for future policy benefits associated with traditional non-participating and limited payment insurance contracts as well as for guaranteed minimum benefits and the amortization model used for deferred acquisition costs. Disclosures as well as presentation of financial results will also change under the new guidance.
January 1, 2021

We are currently evaluating the impact of this guidance on our consolidated financial statements, but expect the impact to the timing of profit emergence for the impacted insurance contracts to be significant. Adoption of certain portions of the guidance may be applied on a modified retrospective basis and others on a full retrospective basis. Early adoption is allowed.



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Reclassifications

In addition to the LIHTC reclassifications discussed above, in 2018 we began reporting our holdings of Federal Home Loan Bank of Des Moines (FHLB) common stock, which we are required to hold as a member of the FHLB system, as other investments rather than equity securities as the stock is restricted in nature. The 2017 consolidated financial statements have been reclassified to conform to the current financial statement presentation.


2. Investment Operations

Fixed Maturity and Equity Securities

Available-For-Sale Fixed Maturity Securities by Investment Category
 
 
 
September 30, 2018
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
 
Non-credit losses on other-than-temporary impairments (1)
 
(Dollars in thousands)
Fixed maturities:
 
 
 
 
 
 
 
 
 
Corporate
$
3,226,039

 
$
148,003

 
$
(60,509
)
 
$
3,313,533

 
$

Residential mortgage-backed
592,376

 
28,761

 
(13,668
)
 
607,469

 
3,026

Commercial mortgage-backed
883,023

 
14,063

 
(32,412
)
 
864,674

 

Other asset-backed
748,415

 
16,410

 
(4,700
)
 
760,125

 
1,364

United States Government and agencies
19,712

 
816

 
(295
)
 
20,233

 

States and political subdivisions
1,456,051

 
87,208

 
(10,268
)
 
1,532,991

 

Total fixed maturities
$
6,925,616

 
$
295,261

 
$
(121,852
)
 
$
7,099,025

 
$
4,390

Available-For-Sale Fixed Maturity and Equity Securities by Investment Category
 
 
 
December 31, 2017
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
 
Non-credit losses on other-than-temporary impairments (1)
 
(Dollars in thousands)
Fixed maturities:
 
 
 
 
 
 
 
 
 
Corporate
$
3,374,927

 
$
329,299

 
$
(15,955
)
 
$
3,688,271

 
$
(504
)
Residential mortgage-backed
483,671

 
35,890

 
(3,280
)
 
516,281

 
339

Commercial mortgage-backed
674,076

 
34,464

 
(3,233
)
 
705,307

 

Other asset-backed
818,071

 
18,645

 
(3,214
)
 
833,502

 
845

United States Government and agencies
23,378

 
1,606

 
(79
)
 
24,905

 

States and political subdivisions
1,383,127

 
141,813

 
(1,239
)
 
1,523,701

 

Total fixed maturities
$
6,757,250

 
$
561,717

 
$
(27,000
)
 
$
7,291,967

 
$
680

 
 
 
 
 
 
 
 
 
 
Equity securities:
 
 
 
 
 
 
 
 
 
Non-redeemable preferred stocks
$
92,951

 
$
7,146

 
$
(265
)
 
$
99,832

 
 
Common stocks
3,764

 
549

 

 
4,313

 
 
Total equity securities
$
96,715

 
$
7,695

 
$
(265
)
 
$
104,145

 
 

(1)
Non-credit losses subsequent to the initial impairment measurement date on other-than-temporary impairment (OTTI) losses are included in the gross unrealized gains and gross unrealized losses columns above. The non-credit loss component of OTTI losses for residential mortgage-backed and other asset-backed securities at September 30, 2018 and December 31, 2017 were in an unrealized gain position due to increases in estimated fair value subsequent to initial recognition of non-credit losses on such securities.




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Available-For-Sale Fixed Maturities by Maturity Date
 
 
 
 
September 30, 2018
 
Amortized
Cost
 

Fair Value
 
(Dollars in thousands)
Due in one year or less
$
116,178

 
$
118,398

Due after one year through five years
545,151

 
562,662

Due after five years through ten years
699,717

 
708,989

Due after ten years
3,340,756

 
3,476,708

 
4,701,802

 
4,866,757

Mortgage-backed and other asset-backed
2,223,814

 
2,232,268

Total fixed maturities
$
6,925,616

 
$
7,099,025


Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Fixed maturities not due at a single maturity date have been included in the above table in the year of final contractual maturity.

Net Unrealized Gains on Investments in Accumulated Other Comprehensive Income
 
September 30,
2018
 
December 31,
2017
 
(Dollars in thousands)
Net unrealized appreciation on:
 
 
 
Fixed maturities - available for sale
$
173,409

 
$
534,718

Equity securities - available for sale

 
7,430

 
173,409

 
542,148

Adjustments for assumed changes in amortization pattern of:
 
 
 
Deferred acquisition costs
(46,865
)
 
(147,173
)
Value of insurance in force acquired
(6,980
)
 
(14,870
)
Unearned revenue reserve
5,673

 
12,705

Adjustments for assumed changes in policyholder liabilities
(64
)
 
(18,499
)
Provision for deferred income taxes
(26,286
)
 
(78,605
)
Net unrealized investment gains
$
98,887

 
$
295,706


Net unrealized investment gains and losses are recorded net of deferred income taxes and other adjustments for assumed changes in deferred acquisition costs, value of insurance in force acquired, unearned revenue reserve and policyholder liabilities. Subsequent changes in the fair value of securities for which a previous non-credit OTTI loss was recognized in accumulated other comprehensive income, are reported along with changes in fair value for which no OTTI losses were previously recognized.

Fixed Maturity Securities with Unrealized Losses by Length of Time
 
 
 
 
September 30, 2018
 
 
Less than one year
 
One year or more
 
Total
 
 
Description of Securities
 

Fair Value
 
Unrealized Losses
 

Fair Value
 
Unrealized Losses
 
 Fair Value
 
Unrealized Losses
 
Percent of Total
 
 
(Dollars in thousands)
 
 
Fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate
 
$
1,008,619

 
$
(41,103
)
 
$
179,151

 
$
(19,406
)
 
$
1,187,770

 
$
(60,509
)
 
49.7
%
Residential mortgage-backed
 
321,318

 
(11,240
)
 
44,511

 
(2,428
)
 
365,829

 
(13,668
)
 
11.2

Commercial mortgage-backed
 
492,258

 
(22,110
)
 
97,859

 
(10,302
)
 
590,117

 
(32,412
)
 
26.6

Other asset-backed
 
301,551

 
(2,819
)
 
93,174

 
(1,881
)
 
394,725

 
(4,700
)
 
3.9

United States Government and agencies
 
3,889

 
(221
)
 
2,423

 
(74
)
 
6,312

 
(295
)
 
0.2

States and political subdivisions
 
218,383

 
(7,995
)
 
16,697

 
(2,273
)
 
235,080

 
(10,268
)
 
8.4

Total fixed maturities
 
$
2,346,018

 
$
(85,488
)
 
$
433,815

 
$
(36,364
)
 
$
2,779,833

 
$
(121,852
)
 
100.0
%


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Table of Contents

Fixed Maturity and Equity Securities with Unrealized Losses by Length of Time
 
 
 
 
December 31, 2017
 
 
Less than one year
 
One year or more
 
Total
 
 
Description of Securities
 
Fair Value
 
Unrealized Losses
 
Fair Value
 
Unrealized Losses
 
Fair Value
 
Unrealized Losses
 
Percent of Total
 
 
(Dollars in thousands)
 
 
Fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate
 
$
85,019

 
$
(1,261
)
 
$
183,820

 
$
(14,694
)
 
$
268,839

 
$
(15,955
)
 
59.1
%
Residential mortgage-backed
 
76,393

 
(1,757
)
 
31,779

 
(1,523
)
 
108,172

 
(3,280
)
 
12.1

Commercial mortgage-backed
 
151,158

 
(2,078
)
 
16,398

 
(1,155
)
 
167,556

 
(3,233
)
 
12.0

Other asset-backed
 
159,111

 
(2,006
)
 
71,064

 
(1,208
)
 
230,175

 
(3,214
)
 
11.9

United States Government and agencies
 
5,698

 
(47
)
 
1,864

 
(32
)
 
7,562

 
(79
)
 
0.3

States and political subdivisions
 
5,904

 
(96
)
 
20,505

 
(1,143
)
 
26,409

 
(1,239
)
 
4.6

Total fixed maturities
 
$
483,283

 
$
(7,245
)
 
$
325,430

 
$
(19,755
)
 
$
808,713

 
$
(27,000
)
 
100.0
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Equity securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Non-redeemable preferred stocks
 
$
2,819

 
$
(71
)
 
$
4,807

 
$
(194
)
 
$
7,626

 
$
(265
)
 
 
Total equity securities
 
$
2,819

 
$
(71
)
 
$
4,807

 
$
(194
)
 
$
7,626

 
$
(265
)
 
 

Fixed maturities in the above tables include 763 securities from 473 issuers at September 30, 2018 and 247 securities from 154 issuers at December 31, 2017.

Unrealized losses increased during the nine months ended September 30, 2018 due to higher market interest rates. We do not consider securities to be OTTI when the market decline is attributable to factors such as interest rate movements, market volatility, liquidity, spread widening and credit quality when recovery of all amounts due under the contractual terms of the security is anticipated. Based on our intent not to sell or our belief that we will not be required to sell these securities before recovery of their amortized cost basis, we do not consider these investments to be OTTI at September 30, 2018. We will continue to monitor the investment portfolio for future changes in issuer facts and circumstances that could result in future impairments beyond those currently identified.

As described more fully in Note 1 to our consolidated financial statements included in Item 8 of our Form 10-K for the year ended December 31, 2017, we perform a regular evaluation of all investment classes for impairment in order to evaluate whether such investments are OTTI.

Credit Loss Component of Other-Than-Temporary Impairments on Fixed Maturities
 
Nine months ended September 30,
 
2018

2017
 
(Dollars in thousands)
Balance at beginning of period
$
(12,392
)
 
$
(14,500
)
Reductions due to investments sold or paid down
3,648

 
1,154

Reduction for credit loss that no longer has a portion of the OTTI loss recognized in other comprehensive income
2,529

 
587

Balance at end of period
$
(6,215
)
 
$
(12,759
)



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The table above sets forth the amount of credit loss impairments on fixed maturities held by the Company as of the dates indicated for which the non-credit portion of the OTTI was recognized in other comprehensive income and corresponding changes in such amounts. Credit loss impairments with no portion of the loss recognized in other comprehensive income, such as securities for which OTTI was measured at fair value, are excluded from the table.
Realized Gains (Losses) - Recorded in Income 
 
 
 
 
 
 
 
 
Three months ended September 30,
 
Nine months ended September 30,
 
2018
 
2017
 
2018
 
2017
 
(Dollars in thousands)
Realized gains (losses) on sales of investments
 
 
 
 
 
 
 
Fixed maturities:
 
 
 
 
 
 
 
Gross gains
$
25

 
$
221

 
$
1,821

 
$
1,426

Gross losses
(1
)
 
(140
)
 
(2
)
 
(1,082
)
Equity securities

 

 

 
(90
)
Other long-term investments
(1
)
 

 
(19
)
 
40

Real estate

 

 

 
305

 
23

 
81

 
1,800

 
599

Net unrealized losses recognized during the period on equity securities held at the end of the period (1)
(732
)
 

 
(3,415
)
 

Net realized gains (losses)
(709
)
 
81

 
(1,615
)
 
599

 
 
 
 
 
 
 
 
Impairment losses recognized in earnings:
 
 
 
 
 
 
 
Other credit-related (2)
(50
)
 
(67
)
 
(1,090
)
 
(133
)
Net realized gains (losses) on investments recorded in income
$
(759
)
 
$
14

 
$
(2,705
)
 
$
466


(1)
See Note 1 to our consolidated financial statements for discussion of change in accounting policy for equity securities during 2018.
(2)
Amount represents credit-related losses for fixed maturities written down to fair value through income and impairment losses related to investments accounted for under the equity method of accounting, which are included in securities and indebtedness of related parties within our consolidated balance sheets.

Proceeds from sales of fixed maturities totaled $59.3 million during the nine months ended September 30, 2018 and $57.7 million during the nine months ended September 30, 2017.

Realized gains and losses on sales of investments are determined on the basis of specific identification.

Mortgage Loans

Our mortgage loan portfolio consists of commercial mortgage loans that we have originated. Our lending policies require that the loans be collateralized by the value of the related property, establish limits on the amount that can be loaned to one borrower and require diversification by geographic location and collateral type. We originate loans with an initial loan-to-value ratio that provides sufficient collateral to absorb losses should we be required to foreclose and take possession of the collateral. In order to identify impairment losses, management maintains and regularly reviews a watch list of mortgage loans that have heightened risk. These loans may include those with borrowers delinquent on contractual payments, borrowers experiencing financial difficulty, increases in rental real estate vacancies and significant declines in collateral value. We evaluate each of our mortgage loans individually and establish an estimated loss, if needed, for each impaired loan identified. An estimated loss is needed for loans for which we do not believe we will collect all amounts due according to the contractual terms of the respective loan agreements.

Any loan delinquent on contractual payments is considered non-performing. Mortgage loans are placed on non-accrual status if we have concerns regarding the collectability of future payments. Interest income on non-performing loans is generally recognized on a cash basis. Once mortgage loans are classified as non-accrual loans, the resumption of the interest accrual would commence only after all past due interest has been collected or the mortgage loan has been restructured such that the collection of interest is considered likely. At September 30, 2018 and December 31, 2017, there were no non-performing loans over 90 days past due on contractual payments. At September 30, 2018, we had committed to provide additional funding for


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mortgage loans totaling $21.1 million. These commitments arose in the normal course of business at terms that are comparable to similar investments.
Mortgage Loans by Collateral Type
 
 
 
 
 
 
 
 
 
 
September 30, 2018
 
December 31, 2017
Collateral Type
 
Carrying Value
 
Percent of Total
 
Carrying Value
 
Percent of Total
 
 
(Dollars in thousands)
Office
 
$
425,459

 
41.9
%
 
$
410,090

 
42.2
%
Retail
 
306,614

 
30.2

 
292,257

 
30.1

Industrial
 
211,585

 
20.8

 
207,180

 
21.3

Other
 
71,960

 
7.1

 
62,285

 
6.4

Total
 
$
1,015,618

 
100.0
%
 
$
971,812

 
100.0
%

Mortgage Loans by Geographic Location within the United States
 
 
 
 
September 30, 2018
 
December 31, 2017
Region of the United States
 
Carrying Value
 
Percent of Total
 
Carrying Value
 
Percent of Total
 
 
(Dollars in thousands)
South Atlantic
 
$
294,262

 
29.0
%
 
$
296,947

 
30.5
%
Pacific
 
164,405

 
16.2

 
146,320

 
15.0

West North Central
 
122,743

 
12.1

 
127,096

 
13.1

East North Central
 
105,982

 
10.4

 
91,971

 
9.5

Mountain
 
102,339

 
10.1

 
105,627

 
10.9

West South Central
 
91,402

 
9.0

 
85,566

 
8.8

East South Central
 
65,459

 
6.4

 
67,228

 
6.9

Middle Atlantic
 
35,123

 
3.5

 
16,052

 
1.7

New England
 
33,903

 
3.3

 
35,005

 
3.6

Total
 
$
1,015,618

 
100.0
%
 
$
971,812

 
100.0
%

Mortgage Loans by Loan-to-Value Ratio
 
 
 
 
 
 
 
 
 
 
September 30, 2018
 
December 31, 2017
Loan-to-Value Ratio
 

Carrying Value
 
Percent of Total
 
Carrying Value
 
Percent of Total
 
 
(Dollars in thousands)
0% - 50%
 
$
404,171

 
39.8
%
 
$
334,037

 
34.4
%
51% - 60%
 
283,036

 
27.9

 
258,359

 
26.6

61% - 70%
 
288,808

 
28.4

 
297,404

 
30.6

71% - 80%
 
21,076

 
2.1

 
63,116

 
6.5

81% - 90%
 
18,527

 
1.8

 
18,896

 
1.9

Total
 
$
1,015,618

 
100.0
%
 
$
971,812

 
100.0
%

The loan-to-value ratio is determined using the most recent appraised value. Appraisals are updated periodically when there is indication of a possible significant collateral decline or there are loan modifications or refinance requests.



15

Table of Contents

Mortgage Loans by Year of Origination
 
 
 
 
 
 
 
 
 
 
September 30, 2018
 
December 31, 2017
Year of Origination
 
Carrying Value
 
Percent of Total
 
Carrying Value
 
Percent of Total
 
 
(Dollars in thousands)
2018
 
$
93,611

 
9.2
%
 
$

 
%
2017
 
209,307

 
20.6

 
214,365

 
22.1

2016
 
150,686

 
14.8

 
154,359

 
15.9

2015
 
134,529

 
13.3

 
144,890

 
14.9

2014
 
75,598

 
7.4

 
77,866

 
8.0

2013 and prior
 
351,887

 
34.7

 
380,332

 
39.1

Total
 
$
1,015,618

 
100.0
%
 
$
971,812

 
100.0
%

 Impaired Mortgage Loans
 
September 30, 2018
 
December 31, 2017
 
(Dollars in thousands)
Unpaid principal balance
$
18,724

 
$
19,027

Less:
 
 
 
Related allowance
(346
)
 
(497
)
Carrying value of impaired mortgage loans
$
18,378

 
$
18,530


 Allowance on Mortgage Loans
 
Nine months ended September 30,
 
2018
 
2017
 
(Dollars in thousands)
Balance at beginning of period
$
497

 
$
713

Recoveries
(151
)
 
(147
)
Balance at end of period
$
346

 
$
566


Mortgage Loan Modifications

Our commercial mortgage loan portfolio can include loans that have been modified. We assess loan modifications on a loan-by-loan basis to evaluate whether a troubled debt restructuring has occurred. Generally, the types of concessions include: reduction of the contractual interest rate to a below-market rate, extension of the maturity date and/or a reduction of accrued interest. The amount, timing and extent of the concession granted is considered in determining if an impairment loss is needed for the restructuring. There were no loan modifications during the nine months ended September 30, 2018 or September 30, 2017.

Variable Interest Entities

We evaluate our variable interest entity (VIE) investees to determine whether the level of our direct ownership interest, our rights to manage operations, or our obligation to provide ongoing financial support are such that we are the primary beneficiary of the entity, and would therefore be required to consolidate it for financial reporting purposes. After determining that we have a variable interest, we review our involvement in the VIE to determine whether we have both the power to direct activities that most significantly impact the economic performance of the VIE, and the obligation to absorb losses or the rights to receive benefits that could be potentially significant to the VIE. This analysis includes a review of the purpose and design of the VIE as well as the role that we played in the formation of the entity and how that role could impact our ability to control the VIE. We also review the activities and decisions considered significant to the economic performance of the VIE and assess what power we have in directing those activities and decisions. Finally, we review the agreements in place to determine if there are any guarantees that would affect our maximum exposure to loss.

We have reviewed the circumstances surrounding our investments in VIEs, which consist of (i) limited partnerships or limited liability companies accounted for under the equity method included in securities and indebtedness of related parties and (ii) non-guaranteed federal LIHTC investments included in other assets. LIHTC investments take the form of limited partnerships, which in turn invest in a number of low income housing projects. We use the proportional amortization method of accounting


16

Table of Contents

for these investments. The proportional amortization method amortizes the cost of the investment over the period in which the investor expects to receive tax credits and other tax benefits, and the resulting amortization is recognized along with the tax benefits as a component of federal income tax expense on our consolidated statements of operations. The net benefits reflected in federal income tax expense related to LIHTC investments were $0.9 million for the third quarter of 2018 and $2.7 million for the nine months ended September 30, 2018, compared to $1.3 million for the third quarter of 2017 and $3.8 million at for the nine months ended September 30, 2017. The carrying value of our LIHTC investments totaled $56.7 million at September 30, 2018 and $65.7 million at December 31, 2017. See Note 1 to our consolidated financial statements for discussion of a change in accounting method applied to these investments.

At September 30, 2018, we had committed to provide additional funds for limited partnerships and limited liability companies in which we invest. The amounts of these unfunded commitments totaled $56.4 million, including $1.6 million for LIHTC investment commitments, which are summarized by year in the following table.

LIHTC Investment Commitments by Year
 
 
September 30, 2018
 
(Dollars in thousands)
2018
$
341

2019
248

2020-2025
996

Total
$
1,585


In addition, we have reviewed the ownership interests in our VIEs and determined that we do not hold direct majority ownership or have other contractual rights (such as kick out rights) that give us effective control over these entities resulting in us having both the power to direct activities that most significantly impact the economic performance of the VIE and the obligation to absorb losses or the right to receive benefits that could be potentially significant to the VIE. The maximum loss exposure relative to our VIEs is limited to the carrying value and any unfunded commitments that exist for each particular VIE. We also have not provided additional support or other guarantees that was not previously contractually required (financial or otherwise) to any of the VIEs as of September 30, 2018 or December 31, 2017. Based on this analysis, none of our VIEs were required to be consolidated for any reporting periods presented in this Form 10-Q.

VIE Investments by Category
 
 
 
 
 
 
 
 
September 30, 2018
 
December 31, 2017
 
Carrying Value
 
Maximum Exposure to Loss
 
Carrying Value
 
Maximum Exposure to Loss
 
(Dollars in thousands)
LIHTC investments
$
56,715

 
$
58,300

 
$
65,710

 
$
67,396

Investment companies
37,388

 
82,167

 
25,335

 
62,372

Real estate limited partnerships
9,694

 
19,522

 
8,589

 
20,590

Other
455

 
649

 
1,182

 
1,488

Total
$
104,252

 
$
160,638

 
$
100,816

 
$
151,846


In addition, we make passive investments in the normal course of business in structured securities issued by VIEs for which we are not the investment manager. These structured securities include all of the residential mortgage-backed securities, commercial mortgage-backed securities and other asset-backed securities included in our fixed maturities. Our maximum exposure to loss on these securities is limited to our carrying value of the investment. We have determined that we are not the primary beneficiary of these structured securities because we do not have the power to direct the activities that most significantly impact the entities’ economic performance.



17

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Derivative Instruments

Our primary derivative exposure relates to purchased call options, which provide an economic hedge against the embedded derivatives in our indexed annuity and universal life insurance products. We also have embedded derivatives within our modified coinsurance agreements as well as an interest-only fixed maturity investment. We do not apply hedge accounting to any of our derivative positions, and they are held at fair value.

Derivatives Instruments by Type
 
 
September 30, 2018
 
December 31, 2017
 
(Dollars in thousands)
Assets
 
 
 
Freestanding derivatives:
 
 
 
Call options (reported in other investments)
$
19,140

 
$
14,824

Embedded derivatives:
 
 
 
Modified coinsurance assumed (reported in reinsurance recoverable)
98

 
2,125

Modified coinsurance ceded (reported in reinsurance recoverable)
20

 

Interest-only security (reported in fixed maturities)
1,422

 
2,096

Total assets
$
20,680

 
$
19,045

 
 
 
 
Liabilities
 
 
 
Embedded derivatives:
 
 
 
Indexed annuity and universal life products (reported in liability for future policy benefits)
$
42,017

 
$
27,774

Modified coinsurance agreements (reported in other liabilities)
288

 
268

Total liabilities
$
42,305

 
$
28,042


Derivative Income (Loss)
 
 
 
 
 
 
 
 
Three months ended September 30,
 
Nine months ended September 30,
 
2018
 
2017
 
2018
 
2017
 
(Dollars in thousands)
Change in fair value of free standing derivatives:
 
 
 
 
 
 
 
Call options
$
5,999

 
$
2,482

 
$
7,039

 
$
6,247

Change in fair value of embedded derivatives:
 
 
 
 
 
 
 
Modified coinsurance agreements
(1,209
)
 
(86
)
 
(2,027
)
 
(1,508
)
Interest-only security
(1
)
 
28

 
(79
)
 
(167
)
Indexed annuity and universal life products
(5,509
)
 
560

 
(2,563
)
 
878

Total income (loss) from derivatives
$
(720
)
 
$
2,984

 
$
2,370

 
$
5,450


Derivative income is reported in net investment income except for the change in fair value of the embedded derivatives on our indexed annuity and universal life products, which is reported in interest sensitive product benefits.

We are exposed to credit losses in the event of nonperformance of the derivative counterparties. This credit risk is minimized by purchasing such agreements from financial institutions with high credit ratings (currently rated A or better by nationally recognized statistical rating organizations). We have also entered into credit support agreements with the counterparties requiring them to post collateral when net exposures exceed pre-determined thresholds that vary by counterparty. The net amount of such exposure is essentially the market value less collateral held for such agreements with each counterparty. The call options are supported by securities collateral received of $14.3 million at September 30, 2018, which is held in a separate custodial account. Subject to certain constraints, we are permitted to sell or re-pledge this collateral, but do not have legal rights to the collateral; accordingly, it has not been recorded on our balance sheet. At September 30, 2018, none of the collateral had been sold or re-pledged. As of September 30, 2018, our net derivative exposure was $5.1 million.



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3. Fair Values

Fair value is based on an exit price, which is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. As not all financial instruments are actively traded, various valuation methods may be used to estimate fair value. These methods rely on observable market data, or, if observable market data is not available, the best information available. Significant judgment may be required to interpret the data and select the assumptions used in the valuation estimates, particularly when observable market data is not available.

In the discussion that follows, we have ranked our financial instruments by the level of judgment used in the determination of the fair values presented above. The levels are defined as follows:

Level 1 - Fair values are based on unadjusted quoted prices in active markets for identical assets or liabilities.

Level 2 - Fair values are based on inputs, other than quoted prices from active markets, that are observable for the asset or liability, either directly or indirectly.

Level 3 - Fair values are based on significant unobservable inputs for the asset or liability.

In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, a financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the financial instrument. From time to time there may be movements between levels as inputs become more or less observable, which may depend on several factors including the activity of the market for the specific security, the activity of the market for similar securities, the level of risk spreads and the source from which we obtain the information. Transfers into or out of any level are measured as of the beginning of the period.

The following methods and assumptions were used in estimating the fair value of our financial instruments measured at fair value on a recurring basis:

Fixed maturities:

Level 1 fixed maturities consist of U.S. Treasury issues that are actively traded, allowing us to use current market prices as an estimate of their fair value.

Level 2 fixed maturities consist of corporate, mortgage- and asset-backed, United States Government agencies, state and political subdivisions and private placement corporate securities with observable market data, and in some circumstances recent trade activity. When quoted prices of identical assets in active markets are not available, our first priority is to obtain prices from third party pricing vendors. We have regular interaction with these vendors to ensure we understand their pricing methodologies and to confirm they are utilizing observable market information. Their methodologies vary by asset class and include inputs such as estimated cash flows, benchmark yields, reported trades, credit quality, industry events and economic events. Fixed maturities with validated prices from pricing services, which includes the majority of our public fixed maturities in all asset classes, are generally reflected in Level 2.

Also included in Level 2 are private placement corporate bonds with no quoted market prices available, for which an internal model using substantially all observable inputs or a matrix pricing valuation approach is used. In the matrix approach, securities are grouped into pricing categories that vary by sector, rating and average life. Each pricing category is assigned a risk spread based on studies of observable public market data. The expected cash flows of the security are then discounted back at the current Treasury curve plus the appropriate risk spread.

Level 3 fixed maturities include corporate, mortgage- and asset-backed and private placement corporate securities for which there is little or no current market data available. We use external pricing sources, or if prices are not available we will estimate fair value internally. Fair values of private corporate investments in Level 3 are determined by reference to the public market, private transactions or valuations for comparable companies or assets in the relevant asset class when such amounts are available. For other securities for which an exit price based on relevant observable inputs is not obtained, the fair value is determined using a matrix calculation. Fair values estimated through the use of matrix pricing methods rely on an estimate of credit spreads to a risk-free U.S. Treasury yield. Selecting the credit spread requires judgment based on an understanding of the security and may include a market liquidity premium. Our selection of comparable companies as well as the level of spread


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requires significant judgment. Increases in spreads used in our matrix models, or those used to value comparable companies, will result in a decrease in discounted cash flows used, and accordingly in the estimated fair value of the security.

We obtain fixed maturity fair values from a variety of external independent pricing services, including brokers, with access to observable data including recent trade information, if available. In certain circumstances in which an external price is not available for a Level 3 security, we will internally estimate its fair value. Our process for evaluation and selection of the fair values includes:

We follow a “pricing waterfall” policy, which establishes the pricing source preference for a particular security or security type. The order of preference is based on our evaluation of the valuation methods used, the source’s knowledge of the instrument and the reliability of the prices we have received from the source in the past. Our valuation policy dictates that fair values are initially sought from third party pricing services. If our review of the prices received from our preferred source indicates an inaccurate price, we will use an alternative source within the waterfall and document the decision. In the event that fair values are not available from one of our external pricing services or upon review of the fair values provided it is determined that they may not be reflective of market conditions, those securities are submitted to brokers familiar with the security to obtain non-binding price quotes. Broker quotes tend to be used in limited circumstances such as for newly issued, private placement corporate bonds and other instruments that are not widely traded. For those securities for which an externally provided fair value is not available, we use cash flow modeling techniques to estimate fair value.

We evaluate third party pricing source estimation methodologies to assess whether they will provide a fair value that approximates a market exit price.

We perform an overall analysis of portfolio fair value movement against general movements in interest rates and spreads.

We compare period-to-period price trends to detect unexpected price fluctuation based on our knowledge of the market and the particular instrument. As fluctuations are noted, we will perform further research that may include discussions with the original pricing source or other external sources to ensure we are in agreement with the valuation.

We compare prices between different pricing sources for unusual disparity.

We meet at least quarterly with our Investment Committee, the group that oversees our valuation process, to discuss valuation practices and observations during the pricing process.

Equity securities:

Level 1 equity securities consist of mutual funds that are actively traded, allowing us to use current market prices as an estimate of their fair value.

Level 2 equity securities consist of non-redeemable preferred stock. Estimated fair value for the non-redeemable preferred stock is obtained from external pricing sources using a matrix pricing approach.

Level 3 equity securities consist of non-redeemable preferred stock for which fair value estimates are based on the value of comparable securities that are actively traded. Increases in spreads used to value comparable companies, will result in a decrease in discounted cash flows used, and accordingly in the estimated fair value of the security.

In the case that external pricing services are used for certain Level 1 and Level 2 equity securities, our review process is consistent with the process used to determine the fair value of fixed maturities discussed above.

Other investments:

Level 2 other investments measured at fair value include call options with fair values based on counterparty market prices adjusted for a credit component of the counterparty, net of collateral received.



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Cash, cash equivalents and short-term investments:

Level 1 cash, cash equivalents and short-term investments are highly liquid instruments for which historical cost approximates fair value.

Reinsurance recoverable:

Level 2 reinsurance recoverable includes embedded derivatives in our modified coinsurance contracts under which we cede or assume business. Fair values of these embedded derivatives are based on the difference between the fair value and the cost basis of the underlying fixed maturities, which are valued consistent with the discussion of fixed maturities above.

Assets held in separate accounts:

Level 1 assets held in separate accounts consist of mutual funds that are actively traded, allowing us to use current market prices as an estimate of their fair value.

Future policy benefits-indexed product embedded derivatives:

Certain index product contracts include embedded derivatives that are measured at fair value on a recurring basis. These embedded derivatives are a Level 3 measurement. The fair value of the embedded derivatives is based on the discounted excess of projected account values (including a risk margin) over projected guaranteed account values. The key unobservable inputs required in the projection of future values that require management judgment include the risk margin as well as the credit risk of our company. Should the risk margin increase or the credit risk decrease, the discounted cash flows and the estimated fair value of the obligation will increase.

Other liabilities:

Level 2 other liabilities include the embedded derivatives in our modified coinsurance contracts under which we cede business. Fair values for the embedded derivatives are based on the difference between the fair value and the cost basis of the underlying fixed maturities.




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Valuation of our Financial Instruments Measured on a Recurring Basis by Hierarchy Levels
 
September 30, 2018
 
Quoted prices in active markets
for identical assets (Level 1)
 
Significant other observable inputs
(Level 2)
 
Significant unobservable inputs
(Level 3)
 
Fair Value